QE3- What It Is and What It Intends to Do

The Federal Reserve, presumably frustrated by high unemployment and a far-from-stellar economic recovery, recently rolled out a new program to stimulate the economy through an open-ended commitment to buy mortgage-backed securities and a pledge to keep interest rates low for at least the next three years. Indeed, the Open Market Committee “is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Therefore, the Fed said it would buy $40 billion of mortgages per month so as to bolster what seems to be the nascent recovery of the United States real estate market. Moreover, it will continue buying back mortgages until the employment situation improves, an unusually strong commitment from the central bank. In addition, it will continue its program of selling shorter-dated government debt and buying longer-term securities, which has come to be known as Operation Twist.

The Fed’s bond buying program, which is known as quantitative easing, is designed to push down long-term interest rates while at the same time encourage investors to head toward other assets, such as stocks. Notably, the Federal Reserve buys mortgage securities and Treasuries from banks and securities dealers through the trading arm of the New York Federal Reserve. As a result, there is reduced supply of these types of investments and yields fall. Lowered rates on bonds will keep mortgage and other consumer rates low. Investors are likely to look to other asset classes, such as stocks, corporate bonds, and commodities (which offer higher returns and a bit more risk), thereby driving up their prices.

Additionally, by purchasing mortgage-backed securities, the Fed is attempting to boost the housing market, which seems to finally be in the early stages of an upswing. Lower interest rates—a 30-year fixed rate mortgage now runs about 3.55%, down from 4.09% a year ago—would undoubtedly give the improvement some wings.

However, many pundits are against the plan. Indeed, the Fed is funding the mortgage purchases with money it effectively creates when it credits the accounts of the bond dealers with funds in exchange for the securities. This may very well lead to a weakening of the dollar, as the Fed is effectively printing more money to fund its purchases. However, Fed Chairman Ben Bernanke has countered this argument by pointing out that those effects ought to spur more spending, investment, and exports, though officials certainly disagree on the size of the benefits.

Moreover, further down the road, the move may spur inflation. The $40 billion monthly expense associated with the third round of quantitative easing dims in comparison to the $1.25 trillion mortgage-bond buying program the Federal Reserve initiated in March of 2009 and a $600 billion Treasury bond-buying program it launched in November of 2010. However, if the labor market does not improve significantly, the Fed has stated that it will continue to buy back mortgage-backed securities, as well as undertake additional asset purchases, and use other policy tools, until the desired improvement in the unemployment rate comes about. Therefore, the new effort certainly has the potential to become much larger.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.